Monday, December 10, 2012

The hot real estate market is boosting the fortunes of Toronto-Dominion Bank.

More than any other Canadian bank, TD has tied itself to the real estate market, ramping up corporate lending to the sector and cashing in on a flurry of equity offerings for real estate investment trusts.

As of early December, the bank’s capital markets arm ranks third in the overall equity league tables, according to Bloomberg, but has the highest share of real estate equity deals, topping even league table leader RBC Dominion Securities. In calendar 2012, TD’s share of equity offerings – after splitting co-lead status amongst all bookrunners – is about $1.6-billion. RBC’s share, which is the second highest, is just north of $1.4-billion.

The same story played out last year, as real estate underwriting helped drive TD to the top of the equity league tables.

TD can thank the Dundee family of REITs for its success. Nearly two-thirds of TD’s $1.6-billion share of real estate deals came out of Dundee REIT, Dundee International REIT and Dundee Industrial REIT.

But the bank is also heavily weighted to real estate in its corporate lending book. As of fiscal year end, TD had about $33-billion in loans outstanding to real estate companies, comprising 31 per cent of its total corporate and government loan book. That’s the highest total and percentage in the Big Five. Bank of Nova Scotia’s loans are more heavily skewed to financial services and retail, while Bank of Montreal’s are more heavily weighted toward service industries and manufacturing.

RBC – TD’s biggest rival – currently has about $21-billion of loans outstanding to real estate companies, comprising about 23 per cent of its corporate lending book.

The question now is how much longer the strength will last. While the real estate sector in Canada has been incredibly hot and retail investors still can’t get enough of their REITs, every sector has its ebbs and flows. Nothing stays hot forever. Just look at the dearth of mining deals for proof.

However, on the corporate lending side, about 30 per cent of TD’s real estate loans are to U.S. companies. Expanding that business could pay off if the U.S. real estate recovery takes shape the way so many people expect it to.

Wednesday, December 05, 2012

Canadian bankers haven't been shy about seizing on the global financial crisis, snapping up assets from U.S. and European peers scrambling to raise cash. None have done so as aggressively as Rick Waugh, chief executive of Bank of Nova Scotia.

The bank is Canada's third-largest by assets, often overshadowed by its bigger and better-known competitors, Royal Bank of Canada and Toronto-Dominion Bank. RBC is pushing to build a world-class investment-banking franchise, while TD Bank has focused on US growth.

But in recent years, Scotiabank has quietly bought up an international portfolio of personal- and commercial-banking assets far surpassing those competitors, while bolstering its retail presence in Canada. Over the past five years, Mr. Waugh has clinched 30 acquisitions, valued at more than $15 billion, by the bank's estimates.

The buying binge puts Scotiabank at No. 2 in the world, behind U.S. Bancorp, in the number of banking deals since 2007, according to Dealogic. It ranks No. 5 for the period, by value, counting only disclosed deals.

"They have really said, 'We are going to be an international bank and be in a position to take advantage of the growth of emerging markets,'" said Paul Cantor, the former chief of National Trust Co., a Canadian lender that Scotiabank bought in 1997.

The overseas acquisitions have helped boost revenue and profit at a time when Scotiabank — which reports quarterly results Friday — and its Canadian peers have struggled to offset weak capital-markets and wealth-management profits. Domestic, retail-banking profits have been strong, but after several years of low interest rates here, Canadians have loaded up on debt. Many economists say they are now tapped out, with lending recently shrinking. Banks have looked abroad for new growth.

Revenue from Scotiabank's international personal and commercial banking surpassed its Canadian banking revenues last quarter for the second quarter in a row, though the domestic unit remains more profitable. The international unit accounted for 26% of the bank's net income last quarter. Overseas profits have grown 46% since 2007, outstripping the domestic retail division's 30% profit growth over the same period.

Mr. Waugh closed his biggest deal — the 3.1 billion Canadian dollar ($3.16 billion) purchase of ING Groep NV's Canadian unit—just a few weeks after elevating a longtime Scotiabank executive as president. That lieutenant is now widely tipped to take over as CEO in as little as a year's time.

Nearing the end of his tenure, the 64-year-old Mr. Waugh (who turns 65 later in December) has more than doubled the bank's assets to some $700 billion since taking over in 2003. Most of that increase has come in the years following the economic crisis.

Mr. Waugh, in an interview, says his push is an extension of the bank's longtime overseas-focused strategy, based on conservative and local personal and commercial businesses.

"It's very straightforward and conservative, but underpinning it is diversification," he said. "It's having the right risk appetite and staying to your fundamental business."

Mr. Waugh has tended to pick off assets in countries from the Caribbean, where the bank has long had a foothold, to emerging markets from Mexico and Brazil to Vietnam and Thailand. His purchases have come from the likes of BNP Paribas SA, Royal Bank of Scotland Group PLC, and Commerzbank AG, as those banks sought to shore up capital or repay government bailouts.

Scotiabank has also moved aggressively into China, agreeing last year to purchase a 20% stake in Bank of Guangzhou. And the bank already has an 18.1% stake in Xi'an City Commercial Bank and owns a 33% stake in a joint-venture fund-management company with Bank of Beijing Co.

But the strategy also carries risks, tethering the bank's fortunes more than many of its peers to the developing world. "It remains to be seen whether by going into all these different countries, whether that's going to pay off well," said Stephen Jarislowsky, chief executive of Jarislowsky Fraser Ltd., one of Scotiabank's largest investors.

After Mr. Waugh's first job as a Scotiabank teller in a strip mall in his hometown of Winnipeg, he quickly rose up the ladder. He moved to Scotiabank headquarters in Toronto, and then around the bank in several, increasingly senior positions — a way the bank's top management has long tested rising stars.

After taking over international and wealth management in 1998, he impressed then-CEO Peter Godsoe by focusing his energies looking for overseas expansion potential, instead of the domestic market. Mr. Waugh is known to preside over marathon meetings, debating and poring over details of potential deals. He's also notorious for mangling names and phrases and mixing metaphors, malapropisms that have come to be known inside the bank as "Rick-isms."

Despite his push to set Scotiabank up for the future, Mr. Waugh holds on to some of the 180-year-old's bank old-world traditions. He marks up documents in red — a carry-over from a Scotiabank tradition of identifying senior managers' input in paper work by the color of their pencils. His expected successor—Brian Porter, who took on Mr. Waugh's title as president on November 1 — uses brown.

Scotiabank was set up in Halifax, the capital of the Canadian province of Nova Scotia, almost two centuries ago. It financed trade in sugar, rum and fish between the West Indies, the U.K. and Canada. It opened an office in Kingston, Jamaica, in 1889, eight years before opening a branch in Toronto. It now operates more branches overseas than in Canada.

Friday, November 02, 2012

Standard Chartered and BBVA have joined the global banks that will be required to hold extra capital because of their importance to the world financial system, the Financial Stability Board announced on Thursday.

Lloyds Banking Group, Commerzbank and Dexia, have dropped off the list of 28 'global systemically important financial institutions.' Dexia is being restructured and Lloyds and Commerzbank are shrinking.

Banks on the list will be required to hold additional capital equal to between 1 per cent and 2.5 per cent of their assets, adjusted for risk, on top of the Basel III minimums, for a total ratio of 8 per cent to 9.5 per cent, starting in 2016.

The Financial Stability Board, made up of regulators, central bankers and representatives of international bodies, plans to update its list of GSifis every November, and the methodology for determining which banks are systemic will also be reviewed every three years.

Currently, banks make the list based on their size, riskiness and importance to the broader financial system.

This year’s announcement also marks the first time regulators have officially stated how big the surcharges will be for each bank.

Previously the expected surcharges were based on estimates.

Citigroup, Deutsche Bank, HSBC and JPMorgan Chase were hit with the top charge of 2.5 per cent.

Most of the banks were on last year’s list and have either boosted their capital ratios or made plans to do so in time to meet the FSB deadline. Both Lloyds and Standard Chartered already have to meet UK requirements, which are stiffer than the global rules.

The GSifi banks and their regulators have also been required to draft “recovery and resolution plans”, also known as “living wills”, that lay out how they could be stabilised or shut down in a crisis.

The FSB said on Thursday that “considerable but uneven progress” had been made.

Cross-border “crisis management groups” of national regulators have been set up for most banks and they have begun reviewing the “recovery” part of the plans, which focus on which business lines could be sold to avoid insolvency.

The FSB said regulators hope to come up with windup strategies for each GSifi bank by the end of the year, with operational plans to follow later.

Wednesday, October 31, 2012

Go for lunch with a bank analyst or any major investor, and odds are one big question will come up: Who is in line to run each of Canada’s major banks when the current boss steps aside?

The job of bank CEO fascinates, because of its high profile at the centre of the Canadian economy, and quite frankly, its huge paycheque.

Bank of Nova Scotia answered the succession question on Wednesday by naming Brian Porter president, with the bank’s key operations reporting to him. It seems very clear that Mr. Porter, long expected to be the heir to chief executive officer Rick Waugh, has officially assumed the title.

But what about the other big four banks? None of them are nearly as obvious as Scotia — or even as clear as Scotia was before Mr. Porter’s promotion.

TD Bank

The background

The bank has been expanding in the United States, and is a major player in the U.S. northeast. It has long focused on retail banking, over and above areas such as wealth management and securities. That means that the likely winner in the CEO race will come from a strong retail banking background. But will it be Canada or the United States?

The incumbent

Ed Clark signalled earlier this year that he was in no hurry to leave. However, at 65, he is not going to be in the chair for another decade.

The candidates

Bharat Masrani

• Mr. Masrani been with TD since 1987, when he joined as a trainee. He has had key roles in risk and wealth management, but it his job running the bank’s huge U.S. operations that makes him a leading candidate for CEO.

Tim Hockey

• Mr. Hockey has come up through the Canadian consumer side of TD, where it is one of the dominant players. He currently runs Canadian banking. Lately, the buzz has been more around Mr. Masrani, but if the U.S. operations stumble, Mr. Hockey could become the leader.

RBC

The background

Canada’s largest bank has been on an expansion tear, adding wealth management and growing its securities and investment banking businesses. But at its heart, it’s still a retail bank. After a long period with an investment banker at the helm, there is a sense that the next person to get the CEO job may be a return to those roots in retail banking.

The incumbent

Gord Nixon has been CEO of RBC for a decade, and is only in his 50s. Like Mr. Clark, he has signalled he is no rush to leave. When he does, there are a number of potential replacements, though of late, just one has set himself apart.

The candidates

David McKay

• Mr. McKay is the head of Canadian banking for RBC, and has emerged lately as the leading candidate to replace Mr. Nixon, both in the view of those outside the bank and many inside it. His business is RBC’s biggest. He hasn’t run many other businesses, but with Mr. Nixon not likely to leave soon, the bank has time to groom Mr. McKay by adding other responsibilities to his CV.

Doug McGregor

• Mr. McGregor is one of the two co-heads of RBC’s investment banking and securities division, which has in recent years expanded from a dominant player in Canada to one that can credibly play with much larger firms in the U.S. market.

Mark Standish

• Mr. Standish is the other half of the co-head tandem in investment banking and securities. He oversees the business from New York, where most of the growth has been. The two investment bankers can take credit for turning a platform that was less than the sum of its parts into something more.

George Lewis

• As head of RBC’s wealth management business, Mr. Lewis has been at the centre of what has been a strategic focus for the bank.

CIBC

The background

CIBC has spent the past five years building a bank that could avoid the kind of mistakes that CIBC made in the credit crisis, which cost the bank billions. That included changing over many senior names in the executive suite, meaning that this is a race that could be won by someone without a long history at the company.

The incumbent

Gerry McCaughey — Mr. McCaughey was given one big job as CEO of CIBC — de-risk the bank. And he has done that admirably. The bank is now a safe, cash-generating company that is very unlikely to end up in big trouble as it has in past. But what’s next? The next person in the top job at CIBC will be charged with finding a way to grow while remaining true to the new safety-first ethos at the bank.

The candidates

Richard Nesbitt

• Mr. Nesbitt has to be considered the leading candidate. He hasn’t been with the bank long in a senior executive role, having come from exchange operator TMX Group Inc. in 2008. But he does have the advantage of having run a large financial company thanks to his role at TMX. At CIBC, he was brought in to run the securities business, but he has been progressively handed more responsibility, including being put in charge of strategy. Inside the bank, he has steadily won over doubters. He is the front-runner.

David Williamson

• Mr. Williamson is another relative newcomer to the banking business, having come from outside CIBC in the post-crisis shakeup. He first worked as chief financial officer before being named head of Canadian retail banking in March 2011.

BMO

The background

BMO is the bank that you don’t hear a lot of succession speculation about. Of the big five banks, its CEO has been in his job the fewest years, so this race has time to develop.

The incumbent

Bill Downe

Mr. Downe has made a big bet on the U.S., building up BMO’s investment banking capabilities there and paying $4-billion to buy a large bank in the midwest. So far, it’s a work in progress, but if it works, he will have differentiated his bank’s strategy and given it a growth engine that it has not had for years.

The candidates

Frank Techar

• Mr. Techar is head of Canadian personal and commercial banking, a business where BMO is not dominant but increasingly seen as more competitive.

Tom Flynn

• Mr. Flynn is the bank’s chief financial officer. The knock on him at this point is he needs experience running a business rather than just overseeing the books. But there’s time in Mr. Downe’s tenure to make that happen.

Monday, October 29, 2012

• We are introducing our 2014 earnings estimates for Canadian banks with expected earnings growth of 9.0% versus 7.6% earnings growth in 2013.

• We believe the bank group's profitability will remain strong in 2014 with ROE expected at 17.5%, down slightly from 18.0% in 2013. CM is expected to lead in terms of ROE at 21.0%, followed by RY and NA at 18.8% and 18.3%, respectively. We estimate RRWA to be very strong at 2.45%, up from 2.35% in 2013, with CM leading the bank group at 3.02% followed by TD and RY at 2.76% and 2.44%, respectively.

• Earnings growth is expected to be led by Wholesale banking earnings as capital markets activity normalizes and Canadian banks gain market share. Wealth Management earnings growth is also expected to be solid.

• We expect domestic Retail banking earnings growth to be 7%-8%, with moderate loan growth and stabilizing retail net interest margins. We believe cost controls will be a major focus for the banks in this segment.

• Banks with International exposure are expected to have higher earnings growth relative to domestically focused banks in 2014.

• We believe share repurchase announcements will accelerate in 2014 as the banks continue to generate excess capital at a high rate. Earnings accretion from share repurchase is expected to offset the potential for weaker-than-expected operating environment.

Increasing Our Share Price Targets for BNS, CM and RY

• We are increasing our share price targets for BNS, CM, and RY to $65, $95 and $70 from $62, $93, and $68, respectively.

Sunday, July 22, 2012

An 80-year-old former games show host hammily promotes the bank with a rictus grin.

Its slogan is “America’s most convenient bank” and, with its Sunday opening hours, it has a fair claim to the title.

But although the company wraps itself in American cheesiness and service standards, it is a Canadian group, TD Bank, that is in full invasion mode.

TD’s growth in the US is part of a trend that is redrawing the map of overseas financial groups’ presence in the country.

According to interviews and an FT analysis of Federal Reserve data, the Canadians are coming in a big way. Meanwhile, some eurozone banks are packing up and many more are selling loans and shrinking as they fight fires on the home front.

For the past few years more of TD’s green and white logos have been put up in US cities as the bank opens accounts and writes mortgages, taking market share from American groups such as Bank of America. “We have completely eclipsed the US peers over that period,” says a confident Colleen Johnston, chief financial officer of TD.

In 2000 TD had $21bn of assets in the US. By 2009, after a series of acquisitions, it was at $170bn. Over the following three years, as US banks such as Bank of America struggled in the crisis and Europeans reduced their presence, TD continued to grow, reaching $251bn of assets, according to the most recent Fed data.

Today Canadian bank assets in the US stand at $654bn, outstripping French banks at $373bn, which have traditionally had a much larger presence.

BNP Paribas shares TD’s colour scheme but not its plans. Though it retains a sizeable presence in the US, with a big wholesale banking operation and a California-based retail bank, Bank of the West, the French bank has been selling assets.

“US banks get their US dollars a lot cheaper these days than the European banks,” says Guido Van Hauwermeiren, head of international coverage, who has had to rethink strategy since the eurozone crisis flared up last summer. “The train went off the track circa August last year and we have been addressing this issue ever since with high liquidity costs.”

Among its deleveraging actions, BNP has sold an energy business to Wells Fargo, one of the few large US banks healthy enough to pursue acquisitions.

While part of the impetus is the need to strengthen capital, a related factor is a lack of dollars. With huge retail operations, US banks have access to plentiful dollar funding in the form of deposits, but many eurozone competitors are reliant on the more fickle funding of money market funds.

“The money market funds that used to be big depositors with European banks took their deposits away from these institutions,” says Mr Van Hawermeiren. “That exacerbated a stress for US dollars for European banks. European banks are revisiting and deleveraging their US dollar consuming operations.”

A US-based executive for another large European bank says: “If you were to say the European banks are pulling in the size of the balance sheets, everyone and their mother is doing that since the crisis – we were criticised for being over-levered and as a liquidity risk management perspective the size of your balance sheet and how much you can actually fund is finite.”

But he insists his bank and other large competitors are trimming their sails, rather than abandoning ship: “In terms of leaving the US or not leaving the US, we would not be spending time, effort and money figuring out US regulatory reform and what we need to do to be compliant if we were pulling out."

The emergent forces in US banking are not just Canadians like TD or stronger megabanks like Wells Fargo.

Capital One, the Virginia-based lender, is another big acquirer. In the past 12 months it bought branches from HSBC and acquired ING’s online banking business.

Much of the global map is being redrawn along national lines, and even stronger groups face increased scepticism from regulators worried about crossborder banking operations.

One key question for the US banking industry is whether Chinese lenders will start to play an important role. Five years ago only $4.4bn of US assets were identified as belonging to Chinese banks. That number has soared to $63.8 billion. While that is still insignificant compared with Canada, it could be the tip of the spear.

In May Industrial & Commercial Bank of China gained US approval to purchase the US subsidiary of Hong Kong’s Bank of East Asia. It was the first time the Fed allowed a Chinese institution to buy an American bank.

Though Chinese lenders – which include the world’s biggest banks by market capitalisation – have taken only a few tentative steps in this direction so far, in time they could join their Canadian peers in the new land grab in the US.

• Our 2012E and 2013E EPS are unchanged at $8.05 per share and $8.80 per share. Our one-year share price target is unchanged at $93 per share based on a target P/E multiple of 10.6x our 2013 earnings estimate.

• We believe CIBC has upside potential to gain market share in various retail and business banking products as it has an 18.6% market share in terms of a domestic branch network, yet only 8.1% market share in CIBC branded mortgages. Clearly the CIBC branch channel is underutilized and has significant upside potential. We reiterate our 1-Sector Outperform rating based on upside potential from retail branch network, industry high profitability and capital, large valuation discount, as well as prospects for significant accretive share buybacks.

NA cash operating earnings increased 10% year over year (YOY) to $1.95 per share, a solid beat. NA increased its annual dividend by 5% to $3.16 per share and announced the intention to reactivate a 2% share buyback program.

• We are increasing our 2012E and 2013E EPS to $7.90 and $8.50 from $7.75 and $8.40, respectively, due to strong results this quarter and strong momentum in retail. Our share price target to remains unchanged at $88.

• We maintain our 3-SU rating due to high relative valuation versus its earnings mix, although the bank has done an excellent job of sustaining its earnings with low volatility.

Wednesday, May 30, 2012

Yesterday, before the open, the bank reported Core Cash (f.d.) EPS of $1.18 versus TD Securities at $1.15 and consensus of $1.15.

Impact

Neutral. It was a reasonable quarter, in our view, with some gives/takes in the underlying composition. Domestic P&C was strong and Wealth was steady while Wholesale was a bit outsized. International was a bit light, but it continues to post strong growth. Credit was also very well behaved. We trimmed our estimates slightly mainly around the outlook for Wholesale, and our Target Price is down slightly. Against that, with the recent weakness in the stock, we see compelling returns from current levels. Concerns around the outlook for global growth are likely to offer some headwinds for the stock in the immediate term, but Scotiabank remains one of the best fundamental stories in the space, in our view. We reiterate our Action List Buy rating.

Details

Continued work on delivering expense leverage. There was a fair amount of acquisition-related noise, but on a segment basis Domestic P&C saw good operating leverage, and management expects it to continue in H2/12. International is struggling to get there consistently, but management continues to suggest that investment spending has leveled off and has now indicated some specific cost cutting measures will hit in H2/12 to deliver positive operating leverage on the year. If successful, this could be an important lever supporting our constructive view on International growth and return prospects.

Thursday, May 24, 2012

• BMO cash operating earnings increased 15% YOY to $1.44 per share, above our expectations of $1.40 per share and IBES at $1.36 per share. The $1.44 includes $72 million after-tax or $0.11 per share related to recovery of provisions for credit losses on M&I purchased credit impaired loans versus $0.13 per share recovery in the previous quarter. Earnings in Q1/12 were $1.42 per share, which included the $0.13 per share recovery.

• Our 2012E EPS is unchanged at $5.75 per share; however, we are trimming our 2013E EPS to $6.20 per share from $6.30 per share. Our one-year target price is unchanged at $66 based on a target P/E multiple of 10.6x our 2013 earnings estimate.

• Maintain 3-Sector Underperform based on high relative P/E multiple given its low relative profitability.

Friday, May 18, 2012

One of the success stories in retail banking over the past decade has been the expansion of TD, Canada’s second-largest bank, along America’s eastern seaboard, fuelled by such basic ideas as longer opening hours and service that is better-than-halfway decent. But a fraud case in Florida threatens to sully the reputation of the firm known to millions as "America's Most Convenient Bank."

TD was the main depository bank for Scott Rothstein, a celebrity lawyer who sold dodgy investments linked to legal settlements. His $1.2 billion Ponzi scheme collapsed in 2009 and he was sentenced to 50 years in jail. Angry investors went after TD, accusing it of “pivotal participation” in the conspiracy. In a court filing plaintiffs alleged, among other things, that TD officers had met with investors to vouch for Mr Rothstein, even conducting “shows” for his structured products at TD branches and corporate offices; that they had misled Rothstein clients about the balances of, and restrictions on transfers from, accounts supposedly held for their benefit; and that the bank had, at Mr Rothstein’s request, moved $16m of investor funds to an account he held in Morocco.

TD has consistently denied engaging in wrongdoing. It settled with one group of investors for $170m. A case brought by another group went to trial, resulting in a $67m award in January, which TD is appealing. This set a worrying precedent for the financial sector as it was the first civil verdict against a bank for aiding and abetting fraud in a case brought by the victims (as opposed to the bankruptcy trustee). “It is a landmark case that will cause banks around the world to shudder,” says Charles Intriago, president of the Association of Certified Financial Crime Specialists.

There may be more trouble ahead for TD. One of the bank’s internal assessments of the money-laundering risks posed by Mr Rothstein had a red bar across the top with “High Risk” emblazoned on it. Those words were mysteriously missing in the version the bank presented to the court, a discrepancy only spotted when the correct version surfaced in another case in which TD is being sued. This matters because the document could be seen as having supported the bank’s defence that it did not consider the lawyer risky and thus did not conduct the enhanced investigations that might have detected the fraud. TD denies having tampered with evidence, blaming the blacked-out bar on a "copying error."

It stands accused of burying documents, too. In a filing on April 24th, TD recanted statements that it and its lawyers had made in court about an internal document called the “Standard Investigative Protocol”, which sets out the bank’s policies on the detection of dirty money. Having said several times that no such document existed, TD eventually produced it and announced that it had replaced its outside legal counsel, Greenberg Traurig, with another firm. One of the Greenberg lawyers representing TD has since left the firm.

Reportedly livid about these developments, the judge who oversaw the $67m award in January, Marcia Cooke, called a hearing to examine whether TD and its lawyers should be held in contempt. At its first session, on May 17th, lawyers for Mr Rothstein’s victims called for extra penalties against the bank and its lawyers—arguing that the award would have been higher had the jury known about the documents—and asked that TD’s pleadings be struck, which, if it were to happen, would cripple its appeal. Judge Cooke appeared to show little sympathy for the bank and Greenberg, reportedly saying: “It is hard for me to describe in words the difficulty throughout this trial related to documents and discovery…It was almost daily.”

This drama is good news for other investors lining up to sue TD. After weighing new evidence, a judge recently gave the go-ahead for another Rothstein-related case to proceed, this one a racketeering suit brought by New York-based Emess Capital. The law permits triple damages in such cases, and some think Emess could walk away with more than $100m. “The cases against TD are helping victims of frauds everywhere to compile a road map on how to recover their losses from deep-pocketed financial institutions,” says Mr Intriago.

On top of this, some expect TD’s regulator in the United States, the Office of the Comptroller of the Currency, to weigh in with enforcement actions and the Department of Justice to bring indictments. At least one of the individuals involved in the document debacle has hired a criminal-defence lawyer. The Rothstein scam may have been small compared with Bernard Madoff’s, but the implications of its collapse for banks and their legal advisers could be bigger.

Wednesday, May 16, 2012

• Banks begin reporting second quarter earnings with Bank of Montreal (BMO) on May 23, followed by Royal Bank (RY) and Toronto-Dominion Bank (TD) on May 24, Bank of Nova Scotia (BNS) on May 29, Canadian Imperial Bank of Commerce (CM) and National Bank (NA) on May 31, Laurentian Bank (LB) on June 6, and Canadian Western Bank (CWB) closing out reporting on June 7.

• We expect second quarter operating earnings to increase 4% year over year (YOY) but decline 5% sequentially from the strong first quarter.

• We expect Wholesale earnings to decline QOQ, Wealth Management to be up moderately, with Domestic/Retail Banking earnings resilient, although growth is slowing (see Exhibit 8). Domestic/Retail Banking earnings are dependent on net interest margin performance as volume growth slows. Overall, our second quarter earnings estimates are in line with consensus.

• We expect bank profitability to remain solid this quarter, although down from highs, with return on equity at 17.5% versus 18.8% in the previous quarter. Return on risk-weighted assets (RRWA) remains extremely high at 2.31% versus 2.41% in the previous quarter.

• The main earnings variables to focus on this quarter, in our view, are trading revenue and the retail net interest margin.

• Trading revenue will likely be negatively impacted by a deterioration in sentiment and increased uncertainty as European sovereign debt concerns resurfaced in March and April. We expect trading revenue to decline 21% QOQ and 7% YOY due to lower fixed income trading revenue (lower underwriting) and lower equity trading volume.

• The sequential trading decline is expected to be impacted by lower fixed income trading revenue, with 10-year Canadian and U.S. government bond yields increasing 15 bps and 12 bps, respectively, and fixed income underwriting activity declining. Canadian government bond and corporate bond underwritings declined by 25% and 20% QOQ, respectively, which is expected to translate into lower fixed income trading volumes. TSX average trading volumes (equity) were relatively soft, declining 3% quarter over quarter (QOQ) and 19% YOY, with block trading volumes down 6% sequentially. The S&P/TSX Composite Index declined 1% in the quarter; however, the majority of the decline in the index occurred in April, with the average value of the index in the quarter up 3% QOQ.

• We expect bank group underwriting and advisory revenue to increase 12% sequentially to $861 million, although down 10% YOY. Underwriting revenue is expected to be led by a 54% QOQ increase in equity issuance, although the lower margin fixed income underwriting is lower as previously noted. M&A activity was up 2% sequentially, although declining 5% YOY.

• We continue to forecast net interest margin compression of 2 basis points per quarter out to the end of 2013. Rational pricing is required to mitigate some of the margin pressure.

• Credit trends remain stable with loan loss provisions expected to be flat at $1.6 billion or 0.37% of loans.

Dividend Increases Unlikely – Timing Discretionary

• Dividend increases this quarter are unlikely with perhaps the exception being NA, as TD, RY, and BNS increased their dividends last quarter, and CWB, NA, and LB increased their dividends in the fourth quarter of 2011.

• The bank group’s dividend payout ratio is currently 45% of our 2012 earnings estimates versus the bank group target payout ratio range of 40% to 50%, so at the midpoint of the range.

• In our view, the strongest candidates for dividend increases in the remainder of fiscal 2012 based on target payout ranges (see Exhibit 5) are LB, NA, CWB, and BMO, followed by CM, TD, BNS, and RY. We expect dividend growth in 2012 to mirror earnings growth in the 6%-7% range. Timing continues to be extremely discretionary.

Bank Share Performance & Valuations - Canadian Housing Concerns

• Canadian bank share prices have outperformed the TSX by 6% in the quarter and 6% year-to-date as at May 14, 2012. As systemic risk from European sovereign debt fears eased in the first 3 months of 2012, the bank beta trade was on, with Bank of America, Citigroup, and JP Morgan up 79%, 42%, and 39%, respectively, versus 11% for Canadian banks. However, an uptick in systemic risk and uncertainty in Europe has resulted in a correction for bank stocks, with Bank of America, Citigroup, and JP Morgan down 26%, 25%, and 22%, respectively from the 2012 highs, versus an 8% correction for Canadian banks.

• We believe Canadian bank P/E multiple expansion has been delayed by increased headline risk and concerns over a Canadian housing correction and slower consumer loan growth, in addition to the uptick in uncertainty from Europe. We believe these concerns have been factored into bank valuations, with U.S. hedge funds potentially short selling Canadian bank shares to take advantage of the increased headline risk.

• We have analyzed the banks' exposure to a housing correction, concluding that price declines would be very manageable for the banking sector especially given the soundness of the Canadian banking system and Canada's relatively strong and stable fiscal position. The Canadian banks have roughly $900 billion in residential mortgage lending exposure (including helocs), with on average 64% insured and 36% uninsured. The insured/uninsured mix varies between the banks, with CM carrying the lowest proportion of uninsured mortgages at 21% and RY the highest at 64%. The average LTV on the uninsured books is 53%, ranging from 48% at CM to 59% at NA. The average LTV on the insured book is 66%, ranging from a low of 49% at CM to 86% at NA (see Exhibit 6).

• We stress tested bank earnings assuming that 10% of total uninsured mortgages were originated at peak house prices and at the maximum LTV of 80% with house prices declining 25%-35% (see Exhibit 7). The stress test also assumes mortgage holders will default when the value of their mortgage is greater than the value of their house. Under this severe stress test, the estimated direct bank earnings impact would be a decline of 5% to 16% with 2012E EPS as a base (see Exhibit 7). We note that the largest peak to trough house price correction in Canada occurred between February 1989 and May 1990, with house prices declining 14%.

• We estimate condos to represent approximately 10% of bank mortgage portfolios, with a guesstimate of 40% of the condo portfolio in Toronto and 20%-25% in Vancouver. If our stress test was applied to the condo exposure only, the direct earnings impact is estimated at approximately 1% to 2%.

• Additionally, historical data shows a strong correlation between house prices and employment levels, with current Canadian employment rate at a very strong 62%. It seems that a 10% house price correction is a reasonable assumption but anything significantly greater than 10%, we believe, would require a major drop in employment levels. A major factor in US house price declines was the collapse in the employment rate compounded by a collapse in underwriting standards which we don't believe we have seen in Canada. CMHC is no Fannie Mae.

• The market continues to chase high dividend yielding sectors, creating valuation premiums in Pipes & Utilities and REITs, while systemic risk has muted bank stock participation. The negative impact of systemic risk on valuations is evident when you compare bank dividend yields versus Pipes & Utilities (see Exhibit 19) and REITs (see Exhibit 20), where systemic risk is relatively low. As systemic risk eased in the first three months of the year, bank stocks began outperforming, with an apparent sector rotation out of Pipes & Utilities and into banks; however, the recent uptick in systemic risk has capped the outperformance. Bank dividend yields are now 1.0 standard deviations above the mean versus Pipes & Utilities and 2.7 against REITs.

• Bank earnings yield relative to Canadian corporate BBB bonds is at an all-time high, even higher than in Financial Crisis I (Lehman Brothers collapse), which is reflective of the level of systemic risk that still persists in bank valuation (see Exhibit 21).

• In fact, if Pipes & Utilities can trade at 20x to 22x earnings, we believe a banks stock can trade at 15x to 17x in a period of low systemic risk and perhaps a period where the market recognizes the decline in the risk premiums post the full implementation of Basel III and the global restructuring of the banking industry.

• We maintain 1-Sector Outperform ratings on TD, RY, and CM, 2-Sector Perform ratings on CWB, BNS, and LB, and 3-Sector Underperform ratings on BMO and NA. We believe CM is the most undervalued stock in the bank group by a wide margin.

Wednesday, February 29, 2012

• BMO cash operating EPS increased 8% YOY to $1.42, above our expectations of $1.40 and IBES at $1.37 due to loan loss recoveries related to the M&I acquisition, partially offset by stock based compensation and lower insurance earnings due to impact of decline in long term interest rates. Wholesale earnings had a partial rebound with retail earnings softening.

Wednesday, February 22, 2012

• Banks begin reporting first quarter earnings with Bank of Montreal (BMO) on February 28, followed by Toronto-Dominion Bank (TD), Royal Bank (RY), and National Bank (NA) on March 1, Bank of Nova Scotia (BNS) on March 6, Canadian Western Bank (CWB) and Laurentian Bank (LB) on March 7, and Canadian Imperial Bank of Commerce (CM) closing out reporting on March 8.

• Canadian banks have converted to International Financial Reporting Standards (IFRS) starting fiscal 2012 (effective November 1, 2011), with the first quarter marking the first earnings reported under IFRS. In preparation for the transition, the banks have provided their 2011 financial position and results of operations under IFRS.

• The overall financial impact on 2011 financial statements is modest. In summary, total assets increased on average 6%, with loan balances increasing on average 19%, and common equity declining 9%. Cash operating EPS impact ranged from -4% to +3%. Return on equity increased 2.0%, to 19.5%.

First Quarter Earnings - 3% YOY Decline, Up 8% Sequentially

• The sovereign debt crisis in Europe continued to heighten systemic risk in the first half of the quarter, leading to capital markets strain and negatively impacting economic growth globally, with Canada not immune. The intensity of the crisis, while still elevated, showed signs of easing in the latter half of the quarter as demonstrated by improving LIBOR-OIS spreads and lower sovereign/global banks CDS spreads.

• We expect a sequential improvement in wholesale earnings off the lows, with wealth management to be stable and retail banking earnings resilient, although growth is slowing. Retail banking earnings are dependent on net interest margin performance/pressure as volume growth slows. Our first quarter earnings estimates are 2% above consensus.

• We expect return on equity (IFRS) to increase to 17.9% versus 17.3% in the previous quarter (16.3% under Canadian GAAP). The improvement in ROE is aided by the transition to IFRS and the resulting reduction in common equity (retained earnings). Return on risk-weighted assets (RRWA) remains extremely high at 2.35% versus 2.21% in the previous quarter.

• The two main earnings variables to focus on this quarter, in our view, are trading revenue and the retail net interest margin.

• Trading revenue will likely remain weak, but is expected to improve quarter over quarter. We expect trading revenue to be $1.4 billion, a 33% increase sequentially but 42% lower year over year (YOY). The sequential trading improvement is expected from fixed income, with 10-year Canadian and U.S. government bond yields declining 39 bps and 32 bps, respectively. Also, fixed income underwriting activity increased both domestically and globally. Government bond and corporate bond underwritings increased sequentially by 11% and 127%, respectively, which is expected to translate into higher trading volumes. TSX average trading volumes (equity) were relatively soft, declining 11% quarter over quarter (QOQ), although the S&P/TSX Composite Index increased 2% in the quarter. M&A activity was solid, increasing 19% sequentially. Overall, we expect bank group underwriting and advisory revenue to rebound by 42% sequentially to $965 million from the very low fourth quarter level.

• The other focus variable is the retail net interest margin. We continue to forecast a decline of 2 basis points per quarter out to the end of 2013. Rational pricing is required to mitigate some of the margin pressure.

• The bank group’s dividend payout ratio is currently 43% of our 2012 earnings estimates versus the bank group target payout ratio range of 40% to 50%, so just slightly below the midpoint of the range. In our view, the strongest candidates for dividend increases in fiscal 2012 based on target payout ranges (see Exhibit 5) are LB, NA, CWB, and TD, followed by BMO, BNS, CM, and RY. We expect dividend growth in 2012 to mirror earnings growth in the 6%-7% range.

• For the quarter, the banks may elect to modestly increase dividends in the 3%-4% range, but may elect to keep dividends unchanged for a 6%-8% increase later in 2012. Timing is extremely discretionary.

Bank Share Performance & Valuations

• Canadian bank share prices substantially outperformed the TSX in 2011 despite systemic risk rising sharply as the European sovereign debt crisis escalated. As systemic risk abates and normalcy returns to the capital markets, we believe bank stocks will be well positioned for another period of strong outperformance.

• The Canadian bank index outperformed the market by 10% in 2011 and is performing in line with the market, up 4% year-to-date as at February 17, 2012. The bank beta trade has been on thus far in 2012, with Bank of America, Citigroup, and JP Morgan up 44%, 25%, and 16%, respectively, versus 4% for Canadian banks.

• In fact, if Pipes & Utilities can trade at 20x to 22x earnings, we believe a banks stock can trade at 16x to 17x in a period of low systemic risk and perhaps a period where the market recognizes the decline in the risk premiums post the full implementation of Basel III and the global restructuring of the banking industry.